The Road Ahead for U.S. Truck Manufacturers

The year 2009 is tracking to go down as the worst year for truck sales in nearly three decades. Based on year-to-date figures, we estimate that 2009 class-8 truck sales will come in below 95,000 units. Although the industry sold a mere 99,000 trucks during 1991, one must go back to the waning days of stagflation--1983--when sales were a mere 82,000, to eclipse today's anemic levels. By all reasonable metrics, truck sales have been stuck in low gear, with substantial headwinds coming from the broader economic slowdown.

As the year--and the economic carnage--recede from view, our gaze turns forward. As grim as the scene in the rear-view mirror is, we think these depressed sales levels are not sustainable, and are spring-loaded for a rebound. Here, we'll explore what the future should hold for truck sales, and highlight ways we think investors could ride the express lane to profits.

Because of its end markets, the truck industry is stubbornly prone to the vicissitudes of the economic cycle. More recently, the trucking industry bore witness to a massive expansion in both housing starts and auto sales. From 2001 through 2006, housing starts averaged 1.8 million, up nearly 20% from its historical average of 1.5 million from 1959 through 2000, according to the United States Census Bureau. In addition, the Bureau of Economic Analysis (BEA) reports that U.S. light vehicle sales averaged 16.8 million units annually from 2001-2006, up nearly 20% from the 14.1 million average annual units between 1976 and 2000.

We believe trucking plays a substantial role in shipping autos and housing goods. During 2002, trucks carried roughly 45% of all car-related products, and 70% of all housing-related products, according to U.S. Department of Transportation statistics. Little wonder, then, that the boom in these industries fueled significant opportunities in trucking.

Armed with these strong market signals, and concerned about the reduction in fuel economy from what were then newly-introduced 2007 engines, truckers over-purchased class-8 trucks during the middle part of the decade. Class-8 trucks have a gross vehicle weight rating (GVWR) greater than 33,000 pounds. The industry purchased an average of 250,000 trucks per year between 2004 and 2006, significantly higher than the average of 167,000 units annually since 1990.

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Shortly after this surge, housing starts started to turn south, and car sales began to falter. What resulted was a massive glut of industry overcapacity. Participant demand began to collapse. Over the following two years, truck sales fell to an average of 126,000 units and, as stated above, we project an anemic 95,000 units for 2009. Interestingly, the trend of truck sales acting as a leading indicator (with an 11-month lead time) going into a recession carries some merit, as trucking industry leadership noted back in 2006 that it was, at that time, already in a freight recession. In contrast, the official overall U.S. recession took hold in December 2007. Using the BEA's data on heavy-duty truck sales--trucks with a GVWR of more than 14,000 pounds--we tracked the predictive power dating back to the data's inception in 1967.

The above table shows that truck sales began to decline nearly 10 months on average before the economy entered a recession. What's striking about the current recession is the sharpness of the decline in sales from the peak. The industry has never experienced such a drastic collapse, even if we count the double-dip recession of 1980 and 1981 as one massive downturn. Based on the magnitude of this decline, we ask what the future will hold for the trucking industry.

The Threat of Substitutes Before delving into our truck forecasts and the implications they could have on our coverage list, we must first address the potential that the trucking industry is in a persistent state of diminishing economic importance.

The above chart depicts the value of goods transported by mode. Over the years, the railroad industry has increased its prominence in shipping goods, but trucks have remained the dominant choice. Although intermodal is the fastest-growing method--trains are roughly four times as efficient as trucks based on weight per ton-mile--the government estimates that trucks will still carry the majority of goods in the future. Part of the reason deals with the geographic limitations of rail. Today, the U.S. Department of Transportation reports that there are 95,000 miles of class 1 railroad track nationally, versus 4 million miles of highways. Since rails face numerous obstacles obtaining right-of-way and deal with significant capital outlays, we believe there will always be a demand for trucks. Furthermore, trucks are the more efficient method of transportation for short-haul routes, despite the operational improvements from the railroads.

Future Truck Forecast Given our more sanguine outlook for the trucking industry, we project that class-8 truck sales could explode over the next few years. That said, the massive prebuy of trucks prior to 2007 likely created a substantial amount of excess inventory within the industry. In fact, we've heard stories of companies shrink-wrapping tractors to preserve them for future use, which corroborates our suspicion.

We've calculated the above excess inventory based on the 13-year median truck sales of roughly 179,000 units per year. Because 2004 was the first year the excessive purchasing began, we used this year as our starting point. As such, we estimate that we will finish 2009 with approximately 48,000 units of excess capacity. Since freight tonnage has been significantly depressed, we believe that most trucks are operationally younger due to underutilization, as measured by mileage rather than by physical age.

Still, assuming normal replacement demand occurs, we expect truck sales will explode over the next two years, increasing on average by approximately 40% per year. The 2010 models will carry price tags that are, on average, $8,000 (or approximately 10%) higher compared with last year. However, because these newer engines boast improved fuel efficiency, we think buyers will be inclined to pay the higher price up front if it means significant fuel cost savings later. In addition, we think trucks enjoy relatively inelastic long-run demand, so any reduction in demand should be short term. Overall, we believe current production levels in both autos and housing aren't sustainable, which is the basis for our bullish forecast. For autos, 2009 will likely see production of about 8.6 million units, with sales of approximately 10 million units this year. However, normalized demand is likely to come in between 12.5 and 15 million units. Given the relatively advanced average age of the existing fleet, future years will likely witness a significant uptick in both sales and production. Similarly, housing will mark its third consecutive year of under-producing normalized demand (between 1.5 and 1.8 million sales), which should serve as another catalyst for improved trucking sales.

Stocks to Put on Investors' Radar Based on our truck forecast, we project that the companies tied to the manufacturing process should reap the benefits, and could present lucrative investment opportunities for long-term shareholders, specifically PACCAR (NASDAQ:PCAR) Cummins (NYSE:CMI), and Rush Enterprises (NASDAQ:RUSHA). Although we would prefer a larger margin of safety with these stocks (the names have rallied substantially as of late from our 5-star prices), we still expect that these companies will see better days ahead.

PACCAR (PCAR) PACCAR manufactures premium nameplates Kenworth and Peterbilt. The company witnessed its U.S. class-8 market share decline during the first half of the year as fleet customers (typically lower value vehicles) overshadowed purchases by owner-operators. That said, the company's year-to-date market share stands around 25%, suggesting fleet owners still have a strong appetite to reward their better drivers with the premium brands. The company is extremely asset-light, has boasted impressive returns on invested capital over the past decade, and is on pace to mark its 71st consecutive year of profitability. Once demand returns, we expect the firm's lean operating style should benefit shareholders tremendously.

Cummins (CMI) Cummins overtook rival Caterpillar (NYSE:CAT) in 2007 as the largest independent class-8 engine manufacturer. Although the firm is losing nearly all of its Navistar (NYSE:NAV) business due to the customer's self-developed engine technology, we believe that Cummins' 2010 engine is superior to the one pursued by Navistar, so Cummins might ultimately regain this business. Furthermore, Cummins will have the opportunity to increase its penetration of Daimler's (DAI) Freightliner models to more than the 6% it has today, as Daimler recently decided to use Cummins' engines after years of sourcing internally. We also think the 2011 off-highway emission standards could create an opportunity for Cummins to increase its market share.

Rush Enterprises (RUSHA) We thought Rush's large parts and service business would help the company survive the downturn, since we figured customers would postpone buying new trucks but not neglect repairs. However, freight declined so severely that truckers deferred most repairs. That said, Rush's absorption rate (an internal metric for profitability of non-truck sales) is higher today than it was during the boom times of 2005. As truck sales improve, the improved absorption rate should enable operating profitability to surge.

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